Xerox Has Long-Term Value

May.13.12 | About: Xerox Corporation (XRX)

Xerox (NYSE:XRX) has a P/E ratio of 7 and a P/OCF ratio under 5. As a result, it trades under book value (!) despite an ROE greater than 10% and operating margins in the high single digits.

Before you dismiss this company out of hand as a dinosaur, consider that this is not your father's Xerox. Just as we've recently seen how Dell is no longer the PC company you thought it was (and therefore may be undervalued as well), neither is Xerox the copier/printer maker of yesteryear. Today, Xerox derives the majority of its revenues and profits from the sale of services (business process, IT and document outsourcing).

And much of these revenues are continuous and predictable; Xerox brags that 83% of its sales are "annuity-based" (up from 82% last year). With many of its sales under contract, but with no one company making up a significant amount of the company's revenue, Xerox can likely be counted on for sustained earnings.

Furthermore, these earnings appear likely to grow. Xerox has been growing revenues at about a 9% per year pace over each of the last three years, and services revenues are expected to grow in the mid-single digits this year as more companies are added under contract. Management also expects margins to expand throughout the year as process improvements allow it to deliver under its services contracts at lower costs.

But there are some issues of which shareholders should be aware. The company does carry almost $10 billion in debt (compared to operating income of $1.5 billion). But it's worth noting that Xerox also finances customer purchases, and has been doing so for years. These finance receivables generate profits for the company, and currently add up to $6 billion, funded to a large extent by this debt.

Xerox also has a pension and retirement plan that is underfunded on the order of $3 billion. While the company only has to pay a nominal amount into its pension plan this year, unless plan asset returns are higher than expected (currently estimated at 6.9% per year) or payouts are lower than expected, this is likely to be a cash drain for the company over the next several years.

There is also the risk that the company deploys more money towards acquisitions that don't pay off. The company has a history of M&A activity, diverting cash flow that could otherwise be used to buy back shares at what is currently a high earnings yield. The fact that management presents an "adjusted" earnings figure that excludes the amortization of intangibles (which were likely paid for as parts of acquisitions) suggests Xerox doesn't see the price paid for acquisitions as particularly important!

With sustainable earnings that are growing, however, it's hard to go wrong at an earnings yield of 13%! Xerox pays a dividend and buys back shares, and therefore may make for a compelling investment at its current price despite its shortcomings.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in XRX over the next 72 hours.